Spotify Can Justify Valuation By Becoming Netflix of Music

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NEW YORK, NY - JANUARY 25: DJ Marshmello performs onstage at 'Spotify's Best New Artist Party' at Skylight Clarkson on January 25, 2018 in New York City. (Photo by Roy Rochlin/Getty Images for Spotify)

Spotify, the Swedish-based music streaming company, is expected to go public at some point before the end of the first quarter with an estimated valuation of nearly $20 billion. In a twist, it will shun the IPO route, bypassing high-priced investment bankers, and instead pursue a direct listing, which enables company insiders to offer their shares for sale on a public exchange.

On the surface, this move seems like a bit of a scam, resembling the countless other offerings in which early shareholders in unprofitable companies look to cash out while leaving the general public to deal with the fallout. Twenty billion is a preposterous number considering that no one has figured out how to make the streaming music model work.

A quick look at the math shows why. For every $10 these services take in, about $6.50 gets distributed to a combination of record labels, artists, publishing companies and songwriters. That doesn’t leave much to cover other costs, explaining why companies such as Amazon and Apple look at music streaming primarily as a loss leader that enhances their broader product ecosystems. Spotify, of course, doesn’t have that luxury: Streaming is its only business.

Spotify could combat this by hiking its fees, but in a world where free music is readily available – including on its own platform – that approach would almost assuredly fail, likely resulting in massive subscriber losses. The key, therefore, is to keep the current fee structure intact and find ways to keep a greater share of the proverbial $10.

It’s virtually the same dilemma that confronted Netflix a few years ago. The company was shelling out millions to television and movie studios for content but not bringing in enough subscription revenue to offset those costs. Very few thought it could ever be profitable, especially as others began to introduce their own over-the-top distribution offerings.

Netflix’s answer was to build a studio. The price tag was enormous, but the result has been a vault of highly valuable content, including “Stranger Things,” “Narcos” and “Orange Is the New Black.” It was one of the savviest decisions by a major company in recent memory, simultaneously reducing Netflix’s reliance on outside content and making the platform indispensable to consumers, so much so that it’s now an existential threat to the entire cable business model.

Spotify needs to do something similar: Rather than pay royalties to record labels, start one of its own, along with perhaps a music publishing company, and deal with the songwriters and artists directly, including producing live performances. Not only would that improve their cost structure, but it would also create an added revenue source since radio stations and other streaming services would be forced to pay for the right to play Spotify-licensed and owned music.

The startup costs involved in an endeavor like this would obviously be enormous as well, but that, in part, is what an IPO is for. With added resources, Spotify can build a label that both provides a pathway toward profitability and becomes an attractive partner for bands and other artists.

If that sounds far-fetched, it’s not. People scoffed at Netflix when it announced plans to start a studio from scratch, saying it would never be able to take on established Hollywood players. It has. Now, actors, directors and producers seek them out.

Spotify has 70 million paid subscribers, and with the number of smartphones expected to grow to 2.5 billion in 2019, the capacity to add millions more. Without a label, though, they can neither make the streaming model work nor justify its current valuation.

Ross Gerber is CEO and president of Santa Monica, Calif-based Gerber Kawasaki Inc., a SEC registered investment advisor with approximately $656 million in assets under management. Gerber Kawasaki clients, firm and employees own positions in Apple, Netflix and Amazon. Readers shouldn’t buy any investment without doing their own research to determine if the investments are suitable to their situation. Please contact us if you have any questions.

I'm the Co-Founder, President and CEO of Gerber Kawasaki Wealth and Investment Management, an SEC Registered Investment Advisor. I oversee Gerber Kawasaki's corporate and investment management operations as well as serve individual clients. I'm is a frequent guest on CNN, C...